Caveat Emptor: Hedge Funds to Mutual Funds…

Morningstar recently publicized plans to change the way they handle the historical track records of mutual funds that have converted from a hedge fund. Currently, they display pre-mutual fund track records with two caveats: they do not include the hedge fund track record in category percentile rankings or when calculating a fund’s “star rating”. The SEC allows fund companies to market the pre-conversion history so Morningstar has included them as well. However, the research team at Morningstar recently concluded that the SEC should change its policy. Leading the way, they will remove pre-conversion track records from their database in the third quarter.

We’ve used this rule when launching new funds at 361 Capital and providing additional data has undeniable advantages to advisors underwriting funds. With that said, the ways in which this rule could be abused are myriad, but to make my point I will give one example of how a firm might go about intentionally or unintentionally misleading potential investors.

Imagine that a mutual fund company has decided to launch a mutual fund in the liquid alternatives space. Since a hedge fund track record can be used to back-fill performance it seems like a great idea to find a top performing fund that has struggled to raise assets. On its own, this isn’t so nefarious, and seems perfectly logical. Given the above goal, the first step would be to screen a hedge fund database for managers with at least a 5-year track record and less than $50 million in assets under management. This may pare the universe down to a few hundred funds (I’m guessing here as I didn’t run the screen). Of those funds left after the screen, there will be 15-20 that have had incredible performance over the last 5 years. Statistically, this is very close to a certainty, even if returns are completely random. Having found 15-20 “targets” the mutual fund company begins approaching mangers of the outlier funds with a proposal to convert the hedge funds to mutual funds. The case for this is compelling: with the current rules, they can keep their incredible track record, market to a much broader audience (that may be inclined to focus on performance more than strategy) and have the potential to raise billions of dollars albeit at lower fees.

So what could be wrong with this scenario? The problem is that skill does not need to be the primary driver, instead past performance is. Some of these funds produced attractive returns on small assets bases utilizing strategies that do not scale easily. Additionally, even in a world without skill there will be managers with great track records that were a function of random luck. These managers’ performance will eventually mean revert and when they do it will be the mutual fund investors who lose. In a couple of recentarticles, Morningstar discussed and quantified this mean reversion.

Source: Morningstar

The difference in excess return pre and post-conversion is a staggering 10% per year, leading credence to the fact that many pre-conversion track records were either a function of randomness or that once constrained by mutual fund rules and regulations, along with an increase in assets, performance was simply not repeatable.

By no means am I implying it is wrong for managers to convert hedge funds to mutual funds or that every conversion will result in poor future performance. In fact, as the chart below shows, many have continued to deliver excess returns post conversion.

Source: Morningstar

I am simply pointing out that data availability feeds investors’ inclination to chase returns, which combined with the inevitable selection bias (few firms are going to convert a poorly performing hedge fund) will often lead to a less than satisfactory outcome. As always, caveat emptor!